A Credit Spread Decomposition: A Resolution of the Credit Spread Puzzle

Robert Jarrow ()

Quarterly Journal of Finance (QJF), 2024, vol. 14, issue 04, 1-14

Abstract: The empirical evidence showing that a corporate bond’s expected loss is only a small portion of a bond’s credit spread is called the credit spread puzzle. This paper, using a reduced-form credit risk model, characterizes a risky bond’s credit spread. This characterization provides a more general measure of a risky bond’s credit risk and it shows that, in an arbitrage-free market, a bond’s credit risk is only a fraction of the credit spread and not linearly related to the one-year, risk-neutral expected loss, resolving the credit spread puzzle.

Keywords: Credit spread; credit risk; default probabilities; recovery rates; bond prices (search for similar items in EconPapers)
JEL-codes: E43 G12 (search for similar items in EconPapers)
Date: 2024
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DOI: 10.1142/S2010139224500162

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